1. Case Study: Examination of an Investment Adviser to a Hedge Fund Dalia Osman Blass, Division of Investment Management Pete Driscoll, Office of Compliance Inspections and Examinations U.S. Securities and Exchange Commission

2. Disclaimer The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission. 2

3. Objective The primary objective of this case study is to learn how an examiner might conduct a review of an adviser’s commercial, operational and compliance processes. Specifically, this case study looks at how an adviser addresses conflicts of interest, advertising issues, and compliance when advising pooled investment vehicles and separately managed accounts. 3

4. Investment Advisers: 3 Affirmative Duties 1.Fiduciary Duty - An adviser has a fiduciary duty to all of its clients, which is to place its client’s interests ahead of its own. In the instance where an adviser has two interests that conflict, advisers must disclose the existence of the conflict to the clients and mitigate it Examples: Allocating favorable investments to certain clients over others; Overstating valuations of securities held in clients’ accounts; Deviating from client mandates in hopes to increase performance 4

5. Investment Advisers: 3 Affirmative Duties 2. A duty to not make false or misleading statements through marketing materials. A false or misleading statement can be made directly to clients or indirectly through an omission of a material fact  Misleading statements typically revolve around an inference of the adviser’s ability to achieve favorable results in the future. Examples: Advertising only profitable recommendations Use of testimonials Guarantees of future results 5

6. Investment Advisers: 3 Affirmative Duties 3. A duty to adopt a comprehensive and effective compliance program. Compliance program must be designed to reasonably address future violations of law  There are two components of a compliance program: A set of tailored and implemented policies and procedures that adhere to the adviser’s business practices and address potential violations of the Investment Advisers Act Designating a Chief Compliance Officer who is competent and empowered to implement the required policies and procedures 6

7. Case Study: Crimson Advisers, Inc. Objective:  The primary objective of this case study is to learn how an examiner might conduct a review of certain conflicts of interest found within a hedge fund environment. As you read through the case study, you will want to consider: Potential risk areas; Whether there are control procedures in place; Additional information you may want to request; and Additional policies and procedures that might be implemented to improve the control environment 7

8. Case Study: Background  Crimson Advisers, Inc. ( Adviser) provides investment advice on a discretionary basis to private investment funds and individually managed accounts. The Adviser provides services to two domestic private investment funds (hedge funds) with aggregate net assets of approximately $800 million. The Adviser also advises ten separately managed accounts (SMA).  The Adviser generally receives a quarterly management fee as well as incentive based compensation.  Sapphire Securities, Inc. (“Sapphire”) acts as the only prime broker to the hedge funds. It also acts as custodian to the SMAs. Pursuant to this arrangement, all transactions clear through Sapphire.  The Adviser uses over 50 different broker-dealers to execute trades and has soft dollar arrangements with several of those broker-dealers.  Garnet Holdings, LLC (Garnet), as GP, has retained Emerald Administrative Services (“Emerald”) to serve as the hedge funds’ administrator. Emerald provides independent verification for the funds and receives transaction information directly from Sapphire. Additionally, the Adviser has entered into a service agreement with Emerald for pricing and valuation of SMA portfolio holdings. Pursuant to the agreements, the portfolio managers agree to send SMAs’ holdings information to Emerald on a monthly basis for independent valuations and risk analysis. 8

9. Case Study: Organization 9

10. Case Study: Disclosure Documents  The PPMs include the following disclosures: The hedge funds pay the Adviser a management fee of 2.00% The GP receives an incentive fee of 20% of net profits Trades will be allocated among the Adviser’s clients based on their relative asset values Third-party brokers and dealers are selected and evaluated based on the benefits and costs of their services as compared to others in the marketplace 10

11. Case Study: Advisory Agreements  Advisory agreements of four of the ten SMA clients contain an incentive fee with a hurdle rate equal to “LIBOR plus 2%”  Six of the SMA clients pay the Adviser an advisory fee of 1.50% of account value and no incentive fee  The advisory agreements incorporate a client/investor questionnaire that collects information regarding net worth and investment sophistication 11

12. Case Study: Books and Records  Form ADV indicates that the Adviser has clients that are high net worth individual investors, hedge funds, pension and profit sharing plans and trusts, estates and charitable organizations  Form ADV states that the Adviser has the authority to select broker- dealers and it seeks best execution  A review of employees’ annual holdings reports revealed that certain of the Adviser’s employees are invested in the hedge funds.  The annual holdings reports of the Adviser’s president and chief investment officer reflected significant investments in hedge funds managed by certain individuals on the list of hedge fund investors referred to above in “Hedge fund books and records”  Presentations given to prospective investors reflect annual total returns of 15% each year  The Adviser sends account statements directly to hedge fund investors 12

13. Case Study: Books and Records  SMA clients receive account statements directly from Sapphire and the Adviser receives copies of those statements  Form ADV states that the Adviser has the authority to select broker-dealers and it seeks best execution. Form ADV further states that the Adviser may pay a broker-dealer a brokerage commission in excess of that which another broker-dealer might have charged for effecting the same transaction, in recognition of the value of the brokerage and research services provided by the broker-dealer  A review of employees’ annual holdings reports revealed that certain of the Adviser’s employees are invested in the hedge funds 13

14. Case Study: Books and Records  The annual holdings reports of the Adviser’s president and chief investment officer reflected significant investments in hedge funds managed by certain individuals on the list of hedge fund investors referred to above in “Hedge fund books and records”  Presentations given to prospective investors reflect annual total returns of 15% each year  The Adviser sends account statements directly to hedge fund investors  SMA clients receive account statements directly from Sapphire and the Adviser receives copies of those statements 14

15. Case Study: Trading Information  A review of the downloaded trade blotter indicates that more profitable trades are allocated to the hedge funds  Periodic analysis of the most and least profitable trades relative to public announcements by those companies (conducted by chief compliance officer (CCO))  Best execution analysis, conducted by investment personnel, comparing execution price to the volume weighted-average price each day and comparing commission rates. Commissions per share paid to all broker-dealers were $0.03 per share; while the commissions per share to Dealer LLC and Trader, Inc. was $0.05 per share  Trade tickets reflecting soft dollar trades to Dealer LLC and Trader, Inc.  CCO conducts periodic acid test of portfolio valuations 15

16. Case Study: Questions 1. What are the potential conflicts of interest and risk areas that should be more fully reviewed and analyzed during the inspections? 2. What control procedures are in place to minimize the impact of these conflicts of interest and risks and how effective do these compliance procedures appear to be? 3. As an examiner, what additional information would you like to know or request from the funds? 4. What additional operational and compliance procedures, if any, should the funds and the adviser implement to reduce risks associated with undisclosed compensation and the improper use of fund assets? 16